Interest Expense: What You Can Deduct and What the IRS Charges

Interest expense is what a borrower pays for the use of someone else’s money. It appears in three places that all follow different rules: your accounting records, your financial statements, and your tax return. The basic math is principal times rate times time, but the amount you actually pay depends on how the interest compounds, and the amount you can deduct depends on why you borrowed the money in the first place.

How the Cost Is Calculated

Every interest calculation starts with three inputs: the principal you borrowed, the annual rate the lender charges, and the length of time you hold the money. Simple interest is Principal × Rate × Time. A $10,000 loan at 5% for one year costs $500. Pay the principal down early and the total drops, because there is less balance for the rate to act on.

Most consumer and business debt does not work that way. Credit cards, most mortgages, and many business loans use compound interest, where the lender charges interest on the interest that has already accrued. The formula is A = P(1 + r/n)^(nt), with “n” the number of compounding periods per year and “t” the number of years. A $10,000 balance at 20% compounded monthly grows faster than the same balance at 20% compounded annually, because each month’s interest is folded into the next month’s calculation.

That gap between the stated annual rate and what you actually pay after compounding is the effective interest rate, sometimes called the effective annual rate. It will always exceed the stated rate when interest compounds more than once a year. A loan advertising 12% compounded monthly carries an effective rate closer to 12.68%. Two loans with the same stated rate can cost meaningfully different amounts depending on how often they compound, so the effective rate is the number to compare.

Fixed and Variable Rates

A fixed rate stays the same for the entire life of the loan. The payment in month one matches the payment in month 300, which makes cash flow easy to plan. Fixed-rate mortgages stay popular for that reason even when variable rates start out lower.

A variable rate is tied to an underlying benchmark and adjusts on a set schedule. When the benchmark rises, your interest expense rises with it. Most variable-rate agreements include a cap on how much the rate can move per adjustment and over the life of the loan. Variable rates generally start lower than comparable fixed rates, but they shift the risk of rising costs from the lender onto the borrower.

How Businesses Record Interest Expense

Businesses report interest expense on the income statement, usually below operating income. The placement is deliberate: investors can see how much profit the core operations generate before financing costs come out. Interest is a cost of how the business is funded, not a cost of running it.

Accounting rules require interest to be recorded when it accrues, not when the payment leaves the account. If a company owes $5,000 in interest this month that will not be paid until next month, it books the $5,000 as expense this period and records a matching liability, accrued interest payable, on the balance sheet. When the cash goes out, the liability clears. This prevents a company from making a quarter look better simply by pushing a payment a few days across the reporting line.

When Interest Gets Capitalized Instead

Some interest does not hit the income statement right away. When a company borrows to build or produce a long-term asset, such as a building under construction or a ship being built, accounting standards require the interest cost to be added to the asset’s value on the balance sheet rather than expensed immediately.¹ The interest is not erased; it comes back later as depreciation once the asset is in use. Routine manufactured inventory does not qualify, so a factory producing identical items every day expenses its interest normally.

What Interest You Can Deduct on Your Taxes

The IRS treats interest very differently depending on what you borrowed the money for. Some interest is fully deductible, some is capped, some phases out with income, and some cannot be deducted at all. The category the interest falls into is what controls the outcome.

Business Interest

Businesses can generally deduct interest paid on business debt, but larger companies face a cap. Under Section 163(j) of the Internal Revenue Code, the business interest deduction in any year cannot exceed the sum of the business’s interest income plus 30% of its adjusted taxable income.² For tax years 2025 through 2029, adjusted taxable income is calculated by adding back depreciation and amortization, which widens the base and raises the ceiling.³

Small businesses are exempt from the 163(j) cap entirely. For 2026, a business qualifies for the exemption if its average annual gross receipts over the prior three tax years are $32 million or less.⁴ The threshold is adjusted annually for inflation.

Any business interest that exceeds the 163(j) limit is not lost. It carries forward indefinitely to future tax years, with the oldest disallowed amounts deducted first.⁵

Mortgage Interest

Homeowners who itemize can deduct interest on mortgage debt secured by a primary or second residence, up to the first $750,000 of debt ($375,000 if married filing separately). The limit, first introduced in 2018, is now permanent.⁶³

Interest on a home equity loan or line of credit is deductible only if the borrowed funds were used to buy, build, or substantially improve the home that secures the loan. Using a HELOC to pay off credit cards or fund a vacation makes the interest nondeductible even though the loan is secured by your house. That restriction is also now permanent.⁶

Mortgage points are treated as prepaid interest. Points paid to purchase a primary home can usually be deducted in full in the year you pay them, provided they reflect standard practices in your area and you funded them yourself at closing. Points paid on a refinance or on a second home are generally spread out and deducted over the life of the loan.⁷

Student Loan Interest

Borrowers repaying qualified education loans can deduct up to $2,500 of interest per year without itemizing. It is an adjustment to income, meaning it reduces adjusted gross income directly.⁸ The benefit phases out at higher incomes. For 2026, single filers with modified adjusted gross income above $85,000 get a reduced deduction, and the deduction disappears entirely at $100,000. For joint filers, the phase-out runs from $175,000 to $205,000.⁴

Investment Interest

If you borrow to buy investments that produce taxable income, such as a margin loan for stocks, the interest is deductible as an itemized deduction. The deduction cannot exceed your net investment income for the year. Net investment income generally covers interest, non-qualified dividends, and certain short-term capital gains from investment property, minus investment expenses.⁹

You can elect to include qualified dividends and long-term capital gains in net investment income to increase the deductible amount, but those gains then lose their preferential rates and get taxed as ordinary income. Any investment interest you cannot deduct this year carries forward indefinitely.⁹

Personal Interest

Interest on credit cards, auto loans, and other personal debt is not deductible under federal law. Section 163(h) of the Internal Revenue Code disallows deductions for personal interest, defining it as any interest that does not fall into an excepted category such as business interest, qualified residence interest, investment interest, or student loan interest.⁹ That is the default. If the interest does not qualify under one of the specific exceptions, no deduction is available.

Interest the IRS Charges You

The IRS charges its own interest when tax is owed and not paid on time. The rate is set quarterly and equals the federal short-term rate plus three percentage points. For early 2026, the rate on individual underpayments was 7% in the first quarter and 6% in the second quarter.¹⁰ IRS interest compounds daily, so even a few months of delay adds up. Interest runs from the original due date of the return, not from any extension deadline, until the balance is paid in full.¹¹

Penalties for Getting a Deduction Wrong

Claiming interest deductions you do not qualify for can trigger the accuracy-related penalty, which adds 20% of the underpayment caused by the error.¹² The IRS applies it when a return reflects negligence or disregard of the rules. The common errors are deducting personal interest as business interest, claiming mortgage interest on debt above the $750,000 cap, and deducting investment interest in excess of net investment income.

Lenders report mortgage interest payments to the IRS on Form 1098, and the agency cross-references that data against what you claim. If the numbers do not match, or you claim mortgage interest with no Form 1098 on file, expect scrutiny. Records that keep deductible interest cleanly separated from personal interest are the simplest defense.

1
Financial Accounting Standards Board (FASB). Summary of Statement No. 34 – Capitalization of Interest Cost
2
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
3
Congress.gov. Tax Provisions in H.R. 1, the One Big Beautiful Bill Act
4
Internal Revenue Service. Rev. Proc. 2025-32
5
eCFR. 26 CFR 1.163(j)-5 – General Rules Governing Disallowed Business Interest Expense Carryforwards for C Corporations
6
Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction
7
Internal Revenue Service. Topic No. 504, Home Mortgage Points
8
Internal Revenue Service. Topic No. 456 – Student Loan Interest Deduction
9
Office of the Law Revision Counsel. 26 USC 163 – Interest
10
Internal Revenue Service. Quarterly Interest Rates
11
Internal Revenue Service. Topic No. 653, IRS Notices and Bills, Penalties and Interest Charges
12
Internal Revenue Service. Accuracy-Related Penalty